Chapter 16

Accounting for Income

Taxes

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Deferred Tax Assets/Liabilities

The Internal
GAAP is the set of
Revenue Code is
rules for preparing
the set of rules for
financial
preparing tax
statements.
returns.

Results in . . . Results in . . .
Usually. . .
Financial statement IRS income taxes
income tax expense. payable.

The difference between tax expense and tax

payable is referred to as deferred taxes.
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Deferred Tax Assets/Liabilities

Example
Examine the December 31, 2003, information
for X-Off Inc.
Revenues $ 1,000,000
Depreciation Expense:
Straight-line 200,000
Accelerated 320,000
Other Expenses 650,000

X-Off uses straight-line depreciation for

financial reporting and accelerated depreciation
for income tax reporting.
X-Off’s tax rate is 30%.
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Deferred Tax Assets/Liabilities

Example
Compute X-Off’s income tax expense
and income tax payable.
Income Tax
Statement Return Difference
Revenues ? ? ?
Less:
Depreciation ? ? ?
Other expenses ? ? ?
Income before taxes ? ? ?

× Tax rate ? ? ?
Income taxes ? ? ?

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Deferred Tax Assets/Liabilities

Example
Compute X-Off’s income tax expense
and income tax payable.
Income Tax
Statement Return Difference
Revenues $ 1,000,000
The income tax
Less:
Depreciation 200,000 amount computed
Other expenses 650,000 based on financial
Income before taxes $ 150,000 statement income
is income tax
× Tax rate 30%
Income taxes $ 45,000
expense for the
period.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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Deferred Tax Assets/Liabilities

Example
Compute X-Off’s income tax expense
and income tax payable.
Income Tax
Statement Return Difference
Revenues $ 1,000,000
Next,
Less:
Depreciation 200,000 compute
Other expenses 650,000 income
Income before taxes $ 150,000 taxes for
the tax
× Tax rate 30%
Income taxes $ 45,000
return.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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Deferred Tax Assets/Liabilities

Example
Compute X-Off’s income tax expense
and income tax payable.
Income Tax
Statement Return Difference
Revenues $ 1,000,000 $ 1,000,000
Income taxes
Less:
Depreciation 200,000 320,000 based on tax
Other expenses 650,000 650,000 return
Income before taxes $ 150,000 $ 30,000 income are
the taxes
× Tax rate 30% 30%
Income taxes $ 45,000 $ 9,000
payable for
the period.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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Deferred Tax Assets/Liabilities

Example
Compute X-Off’s income tax expense
and income tax payable.
Income Tax
Statement Return Difference
Revenues $ 1,000,000 $ 1,000,000 $ -
The deferred tax for the period
Less:
of $36,000 is the 200,000
Depreciation difference 320,000 (120,000)
between
Other income tax650,000
expenses expense 650,000
of -
$45,000
Income before and$income
taxes 150,000tax$ 30,000 $ 120,000
payable of $9,000.
× Tax rate 30% 30% 30%
Income taxes $ 45,000 $ 9,000 $ 36,000

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Deferred Tax Assets/Liabilities

Example
The entry to record the deferred taxes
would appear as follows:

GENERAL JOURNAL Page 77

Post.
Date Description Ref. Debit Credit
2003
Dec. 31 Income Tax Expense 45,000
Deferred Tax Liability 36,000
Income Taxes Payable 9,000

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Temporary Differences
Often, the difference between pretax
accounting income and taxable income
results from items entering the income
computations at different times.

These are called

temporary
differences.
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Temporary Differences

Temporary differences will reverse out in

one or more future periods.

Financial Income > Taxable Income Financial Income < Taxable Income

Future Taxable Amounts Future Deductible Amounts

Deferred Tax Liability Deferred Tax Asset

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Installment sales of  Estimated expenses and

Items
property (installment losses (tax deductible
reported on
method for taxes) when paid)
the tax return
AFTER the  Unrealized loss from
 Unrealized gain from
income recording investments at
recording investments at
statement fair value or inventory at
fair value (taxable when
LCM (tax deductible when
asset is sold)
asset is sold)
 Accelerated
Items  Rent or subscriptions depreciation on tax return
reported on collected in advance (straight-line on income
the tax return statement)
BEFORE the
 Other revenue  Prepaid expenses (tax
income
collected in advance deductible when paid)
statement
The temporary differences in the yellow boxes
create deferred tax assets because they result in
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deductible amounts in the future.
© 2004 The McGraw-Hill Companies, Inc.
 Slide Revenues (or gains) Expenses (or losses)
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Installment sales of  Estimated expenses and

Items
property (installment losses (tax deductible
reported on
method for taxes) when paid)
the tax return
AFTER the  Unrealized loss from
 Unrealized gain from
income recording investments at
recording investments at
statement fair value or inventory at
fair value (taxable when
LCM (tax deductible when
asset is sold)
asset is sold)
 Accelerated
Items  Rent or subscriptions depreciation on tax return
reported on collected in advance (straight-line on income
the tax return statement)
BEFORE the
 Other revenue  Prepaid expenses (tax
income
collected in advance deductible when paid)
statement
The temporary differences in the gray boxes
create deferred tax liabilities because they result
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in taxable amounts in the future.
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Deferred Tax Liabilities

In 2001, Baxter records $100,000 on its books resulting
from revenue earned. The revenue will be taxed as the
cash is collected in 2002 and 2003. Baxter expects to
collect $70,000 in 2002 and the remaining $30,000 in 2003.
2001 2002 2003
Financial Income $ 300,000 $ 200,000 $ 200,000
Installment Sale (100,000) 70,000 30,000
Taxable Income $ 200,000 $ 270,000 $ 230,000
The company is subject to a 32% tax rate.
There are no other temporary differences.

Let’s look at Baxter’s 2001 tax entry.

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Deferred Tax Liabilities

2001 2002 2003
Financial Income $ 300,000 $ 200,000 $ 200,000
Installment Sale (100,000) 70,000 30,000
Taxable Income $ 200,000 $ 270,000 $ 230,000

Income tax expense = $300,000 × 32% = $96,000

Income tax payable = $200,000 × 32% = $64,000

General Journal
Description Debit Credit
Income tax expense 96,000
Income tax payable 64,000
Deferred tax liability 32,000

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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Deferred Tax Liabilities

General Journal
Description Debit Credit
Income tax expense 96,000
Income tax payable 64,000
The Deferred Tax
Deferred tax liability 32,000
Liability
represents the
future taxes Baxter Deferred Tax Liability
will pay in 2002 32,000 2001
and 2003.
2002 2003 Total
Future taxable amounts $ 70,000 $ 30,000 $ 100,000
Enacted tax rate 32% 32%
Deferred tax liability $ 22,400 $ 9,600 $ 32,000
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Deferred Tax Liabilities

2001 2002 2003
Recall this Financial Income $ 300,000 $ 200,000 $ 200,000
information for Installment Sale (100,000) 70,000 30,000
Baxter for 2002. Taxable Income $ 200,000 $ 270,000 $ 230,000

Income tax expense = $200,000 × 32% = $64,000

Income tax payable = $270,000 × 32% = $86,400

General Journal
Description Debit Credit
Income tax expense 64,000
Deferred tax liability 22,400
Income tax payable 86,400
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Deferred Tax Liabilities

General Journal
Description Debit Credit
Income tax expense 64,000
Deferred tax liability 22,400
Income tax payable 86,400

Deferred Tax Liability

2002 22,400 32,000 2001
9,600 Balance
Reversing difference Originating difference

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Deferred Tax Liabilities

2003 Total
Future
Future taxable amounts $ 30,000 $ 30,000
Taxable
Amount Enacted tax rate 32%
Schedule Deferred tax liability $ 9,600 $ 9,600

Deferred Tax Liability

2002 22,400 32,000 2001
9,600 Balance

The Deferred Tax Liability represents the future taxes

Baxter will pay in 2003.© 2004 The McGraw-Hill Companies, Inc.
McGraw-Hill/Irwin
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Deferred Tax Liabilities

Recall the information for Baxter, Inc. for 2003:
2001 2002 2003
Financial Income $ 300,000 $ 200,000 $ 200,000
Installment Sale (100,000) 70,000 30,000
Taxable Income $ 200,000 $ 270,000 $ 230,000

Income tax expense = $200,000 × 32% = $64,000

Income tax payable = $230,000 × 32% = $73,600
General Journal
Description Debit Credit
Income tax expense 64,000
Deferred tax liability 9,600
Income tax payable 73,600
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Deferred Tax Liabilities

General Journal
Description Debit Credit
Income tax expense 64,000
Deferred tax liability 9,600
Income tax payable 73,600

Deferred Tax Liability

2002 22,400 32,000 2001
9,600 Balance
2003 9,600
0 Balance
Reversing difference
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Deferred Tax Assets

Health Magazine received $150,000 of subscriptions in
advance during 2001.
Subscription revenue will be earned equally in 2002,
2003 and 2004 for financial accounting purposes.
The entire $150,000 will be taxed in 2001.
There is additional income of $500,000 in each year.
The company is subject to a 30% tax rate in each year.
2001 2002 2003 2004
Financial Income $ 500,000 $ 550,000 $ 550,000 $ 550,000
Subscription Rev. 150,000 (50,000) (50,000) (50,000)
Taxable Income $ 650,000 $ 500,000 $ 500,000 $ 500,000
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Deferred Tax Assets

2001 2002 2003 2004
Financial Income $ 500,000 $ 550,000 $ 550,000 $ 550,000
Subscription Rev. 150,000 (50,000) (50,000) (50,000)
Taxable Income $ 650,000 $ 500,000 $ 500,000 $ 500,000

This is the computation for the Deferred Tax Asset.

Calculation of Deferred Tax
Asset 2001 2002 2003 2004
Future deductible amount $ 150,000 $ 100,000 $ 50,000 $ -
Tax rate 30% 30% 30% 30%
Deferred tax asset at year-end $ 45,000 $ 30,000 $ 15,000 $ -

Now, let’s record the income tax

McGraw-Hill/Irwin entry for 2001. © 2004 The McGraw-Hill Companies, Inc.
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Deferred Tax Assets

Calculation of Deferred Tax
2001 2002 2003 2004
Asset 2001
Financial Income $ 500,000 $ 550,000 $ 550,000 $ 550,000
Future deductible amount $ 150,000 $
Subscription Rev. 150,000 (50,000) (50,000) (50,000)
Tax rate 30%
Taxable Income $ 650,000 $ 500,000
Deferred$ tax
500,000
asset at$year-end
500,000 $ 45,000 $

Income tax expense = $500,000 × 30% = $150,000

Income tax payable = $650,000 × 30% = $195,000

Description Debit Credit

Income tax expense 150,000
Deferred tax asset 45,000
Income tax payable 195,000
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Deferred Tax Assets

Description Debit Credit

Income tax expense 150,000
Deferred tax asset 45,000
Income tax payable 195,000

Aftertax
Income posting this entry,165,000
expense the Deferred Tax
Asset account
Deferred will have a balance of $45,000.
tax asset 15,000
Income tax payable
Deferred Tax Asset 150,000
2001 45,000
Balance 45,000
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Deferred Tax Assets

In 2002, Health Magazine 2001 2002 2003
earns $50,000 for Financial Income $ 500,000 $ 550,000 $ 550,
financial reporting Subscription Rev. 150,000 (50,000) (50,
Taxable Income $ 650,000 $ 500,000 $ 500,
purposes.

Income tax expense = $550,000 × 30% = $165,000

Income tax payable = $500,000 × 30% = $150,000

In 2002, the Calculation of Deferred Tax

balance in the Asset 2001 2002 2
Future deductible amount $ 150,000 $ 100,000 $
Deferred Tax Tax rate 30% 30%
Asset should Deferred tax asset at year-end $ 45,000 $ 30,000 $
decrease to
Let’s see the income©tax entry for 2002.
$30,000.
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Deferred Tax Assets

Income tax expense = $550,000 × 30% = $165,000
Income tax payable = $500,000 × 30% = $150,000

Description Debit Credit

Income tax expense 165,000
Deferred tax asset 15,000
Income tax payable 150,000

Deferred Tax Asset

Income tax expense 165,000
2001 45,000 15,000 2002
Deferred tax asset 15,000
Balance 30,000
Income tax payable 150,000
Originating difference
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Reversing difference
© 2004 The McGraw-Hill Companies, Inc.
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Deferred Tax Assets

2001 2002 2003 2004
Financial Income $ 500,000 $ 550,000 $ 550,000 $ 550,000
Subscription Rev. 150,000 (50,000) (50,000) (50,000)
Taxable Income $ 650,000 $ 500,000 $ 500,000 $ 500,000

This is the computation for the Deferred Tax Asset.

Calculation of Deferred Tax
Asset 2001 2002 2003 2004
Future deductible amount $ 150,000 $ 100,000 $ 50,000 $ -
Tax rate 30% 30% 30% 30%
Deferred tax asset at year-end $ 45,000 $ 30,000 $ 15,000 $ -

Can you finish Health Magazine’s income tax

entries for 2003 and 2004?
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Deferred Tax Assets

This would be the entry for 2003 and 2004.
Description Debit Credit
Income tax expense 165,000
Deferred tax asset 15,000
Income tax payable 150,000

At the Income
end tax expense
of 2004, the
Deferred tax asset
165,000
balance in the15,000
Deferred
Taxtax
Income Asset
payable would be zero. 150,000
Deferred Tax Asset
2001 45,000 15,000 2002
15,000 2003
15,000 2004
Balance -
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Sharpen Your Pencil . . . There Is

Still More!!

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Valuation Allowance

 A valuation allowance account

is required when it is more
likely than not that some
portion of the deferred tax
asset will not be realized.
 The deferred tax asset is then
reported at its net realizable
value.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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Non-Temporary Differences

Created when an income item is

included in taxable income or
accounting income but will never be
included in the computation of the
other.

Example: Interest on tax-free

municipal bonds is included in
accounting income but is excluded from
taxable income
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Non-Temporary Differences

Also called
permanent
differences.
Disregarded when
determining both taxes
payable and the
deferred tax asset or
liability.
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Tax Rate Considerations

 Deferred tax assets and liabilities

should be determined using the
future tax rates, if known.

 The deferred tax asset or liability

must be adjusted if a change in a
tax law or rate occurs. IRC

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Net Operating Losses (NOL)

Tax laws often allow a company to use tax
NOLs to offset taxable income in earlier or
subsequent periods.

When used to offset When used to offset

earlier taxable income:
 Called: operating loss
carryback.
 Result in a tax refund.
McGraw-Hill/Irwin
future taxable income:
 Called: operating loss
carryforward.
 Result in reduced tax
payable.
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Carryback and Carryforward

Carryback Carryforward
Period Period
-2 -1 +1 +2 +3 +4 +5 . . . +20
Current
Year

The NOL may first be applied against taxable

income from two previous years.
Unused NOL may be carried forward for 20
years.

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Net Operating Losses (NOL)

In 2003 Garson, Inc. incurred an $85,000 net

operating loss. The company is subject to a
30% tax rate. In 2001, Garson reported
taxable income of $20,000, and in 2002,
taxable income was $10,000. The company
elects to carryback the NOL.

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Net Operating Losses (NOL)

Tax Taxable Tax Taxes
year Income rate Paid
2001 $ 20,000 30% $ 6,000
2002 10,000 30% 3,000
In 2003, no taxes are paid and Garson claims a tax
refund of $9,000 for taxes paid in 2001 and 2002.

General Journal
Description Debit Credit
Income tax refund receivable 9,000
Benefits of NOL carryback 9,000

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Net Operating Losses (NOL)

Garson’s Income Statement for 2003 looks like this . . .

Garson, Inc.
Partial Income Statement
For the Year Ended December 31, 2003
Operating loss before income taxes $ (85,000)
Benefit of NOL carryback 9,000
Net loss $ (76,000)

Now let’s look at the treatment of the remaining

NOL of $55,000 ($85,000 - $20,000 - $10,000).
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Net Operating Losses (NOL)

Estimated
Garson prepares this estimate Taxable Enacted Taxes to
of taxable income based upon Year Income Tax Rate be Paid
the best available evidence at 2004 $ 25,000 30% $ 7,500
12/31/03. 2005 25,000 30% 7,500
2006 30,000 40% 12,000

The NOL carryforward will provide a tax benefit of $17,000.

Estimated
Taxable NOL Future Tax
Year Income Carryforward Savings
2004 $ 25,000 $ (25,000) $ 7,500
2005 25,000 (25,000) 7,500
2006 30,000 (5,000) 2,000
McGraw-Hill/Irwin $ (55,000) $ © 2004 The McGraw-Hill Companies, Inc.
17,000
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Net Operating Losses (NOL)

It is likely that Garson will receive the benefits
of the NOL in future periods. As a result, the
following journal entry is made . . .

General Journal
Description Debit Credit
Deferred tax asset 17,000
Benefits of NOL carryforward 17,000

Garson’s income statement for 2003 will

look like this . . .

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Net Operating Losses (NOL)

Garson, Inc.
Partial Income Statement
For the Year Ended December 31, 2003
Operating loss before income taxes $ (85,000)
Benefit of NOL carryback 9,000
Benefit of NOL carryforward 17,000
Net loss $ (59,000)

The deferred tax asset account created by the

benefit of the carryforward will be used to lower
income taxes payable in future years.
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Balance Sheet Classification

Deferred tax Disclose the following:

assets/liabilities  Total of all deferred tax liabilities
are classified as and assets.
current or  Total valuation allowance
recognized.
noncurrent based
 Net change in valuation account.
on the  Approximate tax effect of each
classification of type of temporary difference
the related asset (and carryforward).
or liability.

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Additional Disclosures
 Current portion of tax expense (benefit)
 Deferred portion of tax expense (benefit),
with separate disclosure for
 Portion that does not include the effect of the
following separately disclosed amounts.
 Operating loss carryforwards.
 Adjustments due to changes in tax laws or
rates.
 Adjustments to the beginning-of-the-year
valuation allowance due to revised estimates.
 Investment tax credits.
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Intraperiod Tax Allocation

 SFAS No. 109 requires

intraperiod tax allocation for:
 Income from continuing
operations.
 Discontinued operations.

 Extraordinary items.

 Changes in accounting principle.

 Prior period adjustments (to the

beginning retained earnings).
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End of Chapter 16

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